Economics, environment, mobility, safety

Spot the difference: funding and financing

“Because the Government cannot afford to fix the ailing system, it wants private investors to help foot the bill”. Sounds familiar? This was Tony Blair speaking in 2002 in defence of his proposal to rebuild the London Underground under a public-private partnership.

We have been here before. One of the reasons it did not work as expected in the past and may not work this time round is a fundamental confusion between “funding” and “financing”. Funding is who pays in the end. Financing is who lends the capital in order to get the thing built in the first place, for a return on the loan and in the confident expectation that the capital will eventually be repaid.

On Monday’s [28th November 2011] BBC Radio 4 Today Programme Danny Alexander related how Birmingham Airport is constructing a new runway which is being “paid for” by Canadian pension funds. No it isn’t. Pension funds are helping with the financing but it is the airlines that pay for it (i. e. fund it) through charges to use it.

This confusion was endemic throughout New Labour’s attempt to involve private investors in the provision of public infrastructure. There was a hope that private investors would “step in” to pay for things the taxpayer would not.

The hospital building programme under the Public Finance Initiative is an example. That was a way of committing the taxpayer to fund capital and interest over a thirty year term of a contract. We got new hospital buildings quickly but they were not paid for by the private sector. They are paid for by the taxpayer and it should come as no surprise that we are now facing a pile of annual bills for many years to come.

Infrastructure UK’s first National Infrastructure Plan (October 2010) had it right. It identified £200 billion of new infrastructure necessary to serve our growing population and replacing worn out assets. But it pointed out that in the case of power, water, airports and telecoms there is a mechanism to fund this without involving the taxpayer: through charges to users. That is how investment in infrastructure is paid for ion these industries.

They have a “Regulated Asset Base”. The regulator agrees a set of charges to users which will pay a fair return on the amount pension funds and others have tied up in holding shares of the companies, an amount to maintain and replace the assets, and an amount to fund expansion. All this is on the presumption that the industries behave in an economic and efficient manner—if not they do not get paid for their inefficiencies.

These industries are owned by the shareholders and at the end of the day investment in their infrastructure is paid for—funded—by charges to users. Not by taxpayers.

Pensions funds are pleased to invest—finance—because utilities are long-term, relatively safe investments with a reasonable rate of return, so they match fund managers’ requirements. The demand for electricity or water is not going to unexpectedly disappear. The main risk is that policies or politics will change and cause an unanticipated movement of the goal posts.
Whether investors are Canadian pension funds or the Chinese they will only invest if there is a “bankable” return. That can only come from one of two places: taxpayers or charges to users.

For airports it is relatively easy: there is sufficient demand that charges to customers (airlines) can support new investment. That is what is proposed for the new airport in the Thames. The aviation industry is entirely funded and financed by the private sector. The constraint on airport development is to do with planning permissions, not shortage of capital.
The same is probably true of most power and water investments.

The difficulty comes in cases where there is not enough new income from charges to fund the capital cost, or no new income at all. Many railway investments are not financially viable: High Speed 2 is estimated to cost £32 billion and to leave £17 billion to be funded by the taxpayer. It can be financed but not funded by private investors. HS1, the rail link to the Continent was built largely at the taxpayers’ expense: now it has been possible to sell a thirty year operating concession to a pension fund for £2.1 billion because charges to users are enough to show an operating profit.

A new, free-standing toll road or bridge may be able to generate enough new cash to be entirely privately funded and financed. Whilst there are situations where this approach will work for roads , many of the required improvements are maintenance schemes or relatively small enhancements. It is impractical to charge for these individually. Similarly, prisons, hospitals and schools have no easily identified new cash flow.

In these cases, if no new charging regime is to be introduced, then either the taxpayer pays more or the infrastructure is not built.

So, as the government publishes its priority shopping list of new infrastructure, the question to ask in each case is “how is it going to be funded?” Without a plausible answer, it is pie in the sky to hope the private sector will invest.